The ECB's Game-Changing Solution To The Euro Crisis That's Getting Closer And Closer

The
European Central Bank will release its latest monetary policy
decision tomorrow, and it's likely to take some action to keep
the financial system afloat for at least the next few month or
so.

A flurry of headlines recently suggest that EU leaders are
working on some kind of grand plan to bring Spanish and Italian
borrowing costs under control, but the time frame for such a
project remains unclear.

Even so, our friend and Chief Europe Strategist at Trend
Macrolytics tells us, there's reason to believe that the ECB is
not far from embarking on a sequence of measures that will
ultimately renew faith in struggling sovereigns like Italy and
Spain.

In particular, Draghi could announce that he wants all sovereign
bond yields to converge to within 300-400 basis points (this
number could vary) of the benchmark yields, those on German
bunds. In other words, Draghi would announce the ECB's
intent to buy as many Spanish and Italian bonds as it would take
to bring borrowing costs for both sovereigns closer
together.

This would eliminate the disparity between German borrowing
costs—at record lows—and Spanish and Italian borrowing costs,
which are spiraling out of control. Adopting stronger
crisis-fighting measures is currently to the detriment of the
German, French, and other Northern European governments because
those countries can borrow with unprecedented ease. This, then,
is a barrier to progress across the pond.

ECB yield targeting would remove this roadblock, Roche Kelly
reasoned. Germany and France would no longer have reason to
oppose at least partial debt mutualization in eurobonds,
diminishing tensions in financial markets.

Essentially, the ECB could single-handedly resolve the financial
tensions of the crisis. Such actions are arguably within the
central bank's power, and a likely return to its bond-buying
program is a strong step in the direction of yield targeting.

That said, Roche Kelly noted that the ECB will probably wait to
do this until EU leaders have made more concessions that will
resolve the lack of political, economic, and fiscal union in the
eurozone. Those developments are key to making sure growth
returns to the region.

We have one important problem with this plan:
timing.

Germany has largely been able to avoid the ill effects of the
crisis, with low unemployment and only a slight hit to GDP
growth. Should the economic situation there deteriorate, however,
that could ultimately be reflected in German yields. High yields
converging could still lead to eurobonds, but doubts about the
viability of all European sovereign debt would
prolong the crisis.

Admittedly, the German economy might be able to carry the weight
of Europe. However, rising yields on German bunds late last year
suggested that Germany might not be quite as safe as investors
would like to believe.